Does Schlumberger Pass Buffett's Test?

We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, in order to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we take a look at several companies in a single industry to determine their ROIC. Let's take a look at Schlumberger (NYSE: SLB  ) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's actually creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

The nuances of the formula are explained in further detail here. This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for four industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Schlumberger 12.3% 9.7% 24.7% 25.5%
Baker Hughes 10.6% 5.4% 21.6% 24.6%
Halliburton 19.2% 15.1% 25.8% 23.7%
Weatherford International 3.1% (0.8%) 11.0% 10.4%

Source: S&P Capital IQ. TTM = trailing 12 months.

Halliburton (NYSE: HAL  ) has by far the highest returns on invested capital of the listed companies, but its returns have fluctuated over the five-year period and are 3.5 percentage points lower than they were five years ago. Schlumberger has the next highest ROIC, but its current returns are less than half of what they were five years ago. Baker Hughes (NYSE: BHI  ) has also seen massive declines in its ROIC over the five-year period, but like Schlumberger, it has improved its returns from last year. Weatherford (NYSE: WFT  ) has also seen its returns suffer over the same time period and rebound over the past year, but its current returns are nowhere near those of peers. Also, Weatherford fails to offer a dividend, while its competitors all offer modest dividends in the 1% range.

Schlumberger is a giant in the oil services industry, providing drilling and well-related services, as well as seismic services. Its market cap is far larger than the combined market cap of Halliburton, Baker Hughes, and Weatherford. It has also worked with Petrobras and Chesapeake Energy to gain access to lucrative projects and techniques. However, with companies like Halliburton, Baker Hughes, Weatherford, and National Oilwell Varco (NYSE: NOV  ) pursuing niche strategies, Schlumberger's large size and scope does not guarantee a competitive advantage. It must continue to act aggressively to maintain its dominance in the face of these challenges.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.

So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. If you'd like to add these companies to your watchlist, click below:

Jim Royal, Ph.D., does not own shares of any company mentioned here. The Motley Fool owns shares of National Oilwell Varco. Motley Fool newsletter services have recommended buying shares of Schlumberger, Chesapeake Energy, National Oilwell Varco, and Petroleo Brasileiro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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